Westpac has been flooring risk-weights on retail exposures to prepare for tighter capital requirements from the Australian Prudential Regulation Authority (Apra) and a roll-off of Covid support measures, with overlays inflating risk-weighted assets (RWAs) by A$9.4 billion ($7.1 billion) as of end-September.

The bank first floored risk density – the ratio of RWAs to exposures at default (EAD) – on internally-modelled residential mortgages at 23.8% in the three months to end-March, later rising to 25%.

As of end-September, the floor had produced A$8.8 billion in extra RWAs, inflating total RWAs by 7%. The impact on introduction, at end-March, was A$3.3 billion, for a 3% increase.

Overlays also affected the Australian credit card portfolio, where risk density was floored at 26% since the quarter ending in March. At end-September, the floor had inflated RWAs by A$6 billion, or 19%.

What is it?

RWAs are used to determine the minimum amount of regulatory capital that must be held by banks. Each banking asset is assessed on its risk: the riskier the asset, the higher the RWA – and the greater the amount of regulatory capital that must be put aside.

Westpac models the overwhelming majority of its credit portfolios using in-house approaches (99% of residential mortgage EADs and the entirety of the Australian credit card book), as opposed to the regulator-devised standardised approach.

Why it matters

Westpac said the decision to floor retail risk-weights stems from an “expectation that mortgage risk-weights will rise from Apra’s capital changes, and [from] some rise in mortgage stress [that] may emerge once Covid-19 stimulus unwinds.”

That calculus dovetails with two trends that have emerged in richer economies post-Covid, and that have been likely keeping regulators awake at night.

On one hand, there’s a question mark hanging over the future trajectory of loans that have benefited from relief measures through the pandemic’s peak, such as payment holidays or stimulus checks. There have been signs, across jurisdictions, that ending relief measures could precipitate a deluge of defaults by weaker borrowers.

On the other hand, house prices in already-hot markets like the UK, the Netherlands and, indeed, Australia have been on a relentless rise despite worries about renewed lockdowns, resurgences in unemployment and growth-crippling inflation. The Bank of England and the Dutch Central Bank have both set out plans to keep mortgage volumes in check, or at the very least make sure banks are appropriately weighing home borrowers’ risk.

Apra has recently taken a step in the same direction, tightening the mortgage serviceability assessment process. Eventually introducing outright capital floors may be not that much further of a step – one Westpac evidently wants to be prepared for.

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